Monetary Policy, Inflation and Capital Markets

Please find attached an article 'Monetary Policy, Inflation and Capital Markets' that appeared in the Independent Financial Review yesterday, 7 March 2007.

Monetary Policy, Inflation and Capital Markets

Promoting discussion and public understanding about monetary policy and financial markets is important. A stable currency and the efficient allocation of capital in the economy matter for economic growth and living standards. There is room for fair debate about relevant policy issues.

Some things are clear. One is, in Milton Friedman’s famous formulation, that “inflation is always and everywhere a monetary phenomenon”, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output. Central bankers should recite these words to themselves every morning.

It is hard to over-emphasise the importance of this insight, which has revolutionised thinking and practice worldwide in the last 25 years. The defeat of inflation through better monetary policies has been of enormous benefit in many economies, including New Zealand.

Inflation is an ongoing increase in the general level of prices, not the relative ups and downs in prices that occur all the time in a market economy, and are so important for its functioning.

Friedman’s point is that inflation cannot be sustained unless the central bank accommodates an increasing demand for money. It alone is responsible for controlling the money supply and thereby inflation.

To be sure, there are long and variable lags in the operation of monetary policy, as Friedman also pointed out: These may have changed in New Zealand with the growth in fixed-rate mortgages. However, that does not change Friedman’s basic point; the Reserve Bank simply has to use its best judgment about them in assessing whether or not to tighten monetary conditions.

The extent of this revolution in monetary thinking is apparent when we look back on earlier government reactions. In the 1960s and ‘70s when inflation increased worldwide, governments in New Zealand and elsewhere responded to inflationary pressures with expedients such as wage and price controls and ceilings on bank lending. None of them worked more than temporarily. Disinflation was not achieved until governments moved to what we now regard as orthodox monetary policies targeted directly at inflation.

We seem to be at risk of forgetting earlier lessons. In recent years the Reserve Bank has talked a lot about housing prices, consumer spending, debt and the balance of payments. The minister of finance has canvassed the idea of a tax on home mortgages, and has resisted tax reductions on inflationary grounds.

Recent levels of inflation and inflationary expectations are indeed a matter of concern. However, their source is much more likely to be the Reserve Bank’s tolerance of an excessive growth in the money supply and the successive moves to loosen the Policy Targets Agreement. Persistent inflation of around 3 percent per annum is not consistent with the legislated goal of price stability.

House price increases by themselves should not be a matter of concern from a monetary policy perspective. New Zealand house prices have risen less than those of a number of other countries. In many respects they are an outcome of the better performance of the economy since the early 1990s, rising employment, positive net migration and historically low real interest rates. Farm prices and those of other assets have risen too. There is no reason to discriminate against lending to any sector. In respect of housing, the focus instead should be on key distortions such as council policies and RMA processes that are restricting land supply and making new houses much more expensive than they should be.

Tax policies need to be determined by sound tax policy criteria and not be confused with monetary policy issues. Changes in taxes can have one-off effects on asset and goods prices but they cannot affect the ongoing rate of inflation. We saw this with the introduction of GST. Whether countries impose capital gains taxes on housing or not, for example, makes no ongoing difference to their inflation performance.

Thus discussion of New Zealand’s non-resident withholding tax on interest or the Approved Issuer Levy, to take another example, should focus on whether they contribute to raising necessary government revenue at the least economic cost. Relative to debt, the priority would appear to be a reduction in the level of taxation on equity investment, which pushes up the cost of capital in New Zealand.

There are also many issues that affect the efficiency and depth of New Zealand’s capital markets, not the least of which has been spiralling regulatory costs in recent years, the extent of government ownership of commercial enterprises and levels of government spending and taxation that have crowded out private saving. Again, however, these have nothing to do with ongoing inflation.

The bottom line is that when it comes to inflation, the buck stops with the Reserve Bank. Its charter needs to be defended and it must execute it competently. Other policies should be considered on different criteria. Misguided policies in respect of labour law, business regulation, government spending, tax, land supply, building controls, infrastructure and many other things can make the Bank’s job harder, but their main impact is not on monetary policy and inflation. Rather, it is to undermine economic growth and make New Zealanders unnecessarily poorer.

Roger Kerr is the executive director of the New Zealand Business Roundtable.

ENDS

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